From the below reading, was the negotiating bank justified in refusing to honor their clients drawing, especially given the financial challenges faced by TLP?

Case Study #5: Being PreparedPlunging Into the International Marketplace

Leather goods machinery - the soft touch?

A medium size specialty leather goods designer and manufacturer, Tuscany Leather Productions (TLP), located in a large town outside Florence has had good success in developing their own line of gloves, handbags and other accessories, and has distributed them across Europe. Cross border transactions have been facilitated by documentary collections and open account. TLP has experienced occasional delays in payment, but they have been satisfied with the overall results and are anxious to expand production and export outside Europe to increase revenue. Much of TLPs success has been their unique designs due to the specialty machinery and processes they have developed.

TLP was recently approached by a large leather manufacturing company in Korea, Korean Soft Goods Manufacturing (KSM,) to purchase one or more of TLPs specialty machines and to enter into an agreement to implement and monitor the unique processes in the Korean factories.

Reaction

The sale of specialized machinery and processes is not something TLP had planned or anticipated. The approach from KSM was unexpected, but exciting and flattering. The price of more than US$1 million for the entire contract was also very tempting. TLP did not have detailed knowledge of KSM but they had heard of them in the market and were familiar with the goods they produced.

One of the first challenges for the Italians was how to produce the machinery in the timeframe discussed and how this would affect their limited financial and physical resources. The impact on normal production was considered and TLP concluded that they could manage with the addition of part-time factory workers. Having decided they had the physical capability, TLP approached their local bank for advice on how to finance the production of the new machinery and on how best to secure the sale to the Koreans. The local bank had little experience in international transactions outside Europe but TLP had a long history with this bank, Banca di Toscana (BT) and relied on

them from the inception of TLP for advice and financing. They were content to accept advice - and financing - from their longstanding bankers. After a visit to Korea by senior management from TLP to meet their counterparts and tour the factory, the companies agreed to enter into a contract together in the form of a Purchase Order.

The Deal

While the Koreans had expressed an interest in more than one machine, TLP wanted to test themselves, and KSM, by only agreeing to sell one machine at a price of US$720,000 plus implementation and monitoring services extended over a period of one year, for an additional US$280,000. TLP required a documentary letter of credit to be issued by a Korean bank and to be confirmed by Banca di Toscana for a total of US$1 million. The letter of credit was to be valid for the life of the transaction, including progress payments for the services portion.

Cracks below the surface

Based on the signed purchase order the Italian Company was able to secure pre-export financing from their bank for about 50% of the sale price of the machinery to be disbursed at different stages, most importantly, when the letter of credit arrived. TLP began preparations, purchased raw materials and finalized the design of the new machine and was anxious to receive the letter of credit.

Later, when they inquired of the Korean Company about the status of the letter of credit, KSM informed them that they were awaiting the issuance of a performance bond by TLPs bank. The provision of a performance bond had not been previously discussed, but KSM were insistent it be issued before they would authorize the issuance of a letter of credit.

TLPs bank was not pleased with the news that the company would be required to utilize a larger portion of their existing line of credit to secure the performance bond. They cautioned TLP that this would impact the size of the pre-export loan. The bank further advised that a per annum fee of 3% of the value of the US$200,000 performance bond would be applied. The performance bond was to be valid for six months beyond the finalization of the contract.

A week following the issuance of the performance bond a letter of credit was received by Banca di Toscana, issued by a small Korean bank. The issuing bank asked the Italian advising bank to add its confirmation before sending it to the beneficiary. The issuing bank was not known to BT and they did not have any pre-established credit limits in place for this bank, which would have allowed them to confirm the letter of credit.

TLP, while naive and unfamiliar about the full workings of letters of credit, insisted they would not ship unless the letter of credit was confirmed. Their bank in turn successfully sought another bank which would be prepared to assume the issuing bank and country risk and BT sold the underlying risk to this third bank. Given the perceived higher risk of the issuing bank and the need to involve two banks in the confirmation process, the fees were almost twice as much as expected by the Italian Company.

Moving ahead

Production proceeded, but slower than planned, requiring the expiry and shipping dates of the D/C to be amended. Financing from BT was not as much as promised or expected. They were concerned about production and the impact the project was having on normal business activities, including sales. Individual owners of TLP were required to contribute cash to the project and to provide added security to the bank.

Shipment of the machine took place three months later than originally planned. The services of logistics specialists and a freight forwarder were acquired only three weeks before shipment. The costs associated with these service providers were unplanned. Documents were presented to the bank for negotiation (payment) one week before the expiry date.

All the documents were checked carefully by BT, and a number of discrepancies were found, including "late shipment". The bank refused to honour their confirmation undertaking because of the discrepancies and would not pay the beneficiary unless the issuing bank approved the discrepancies. TLP was certain, given the relationship they had developed with KSM that the Korean company would waive the discrepancies and authorize payment, in effect accepting the documents as tendered. The next day TLP was contacted by KSM to express their disappointment with the delay in shipment and the other discrepancies.They insisted on a reduction in the price of US$20,000 before they would waive the discrepancies and authorize payment.

Tuscany Leather Productions was now faced with a situation which grew more serious by the day; the entire project had consumed more time and resources than expected or planned, and the cost of financing and other fees far exceeded expectations. Now the goods were on the high seas, approaching Korea and the buyer was threatening to withhold payment unless TLP agreed to a substantial reduction in the price. Refusal to agree to the reduction could result in the goods being held in Korea and returned to Italy if another buyer could not be found, which would be difficult given the specialized nature of the machinery. High continuing demurrage charges (storage charges) would be incurred.